THE BUSINESS SITUATION Greetings Inc. stores, as well as the Wall Décor division
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Question
THE BUSINESS SITUATION
Greetings Inc. stores, as well as the Wall Décor division, have enjoyed healthy profitability
during the last two years. Although the profit margin on prints is often
thin, the volume of print sales has been substantial enough to generate 15% of
Greetings’ store profits. In addition, the increased customer traffic resulting from
the prints has generated significant additional sales of related non-print products.
As a result, the company’s rate of return has exceeded the industry average during
this two-year period. Greetings’ store managers likened the e-business leverage created
by Wall Décor to a “high-octane” fuel to supercharge the stores’ profitability.
This high rate of return (ROI) was accomplished even though Wall Décor’s
venture into e-business proved to cost more than originally budgeted. Why was
it a profitable venture even though costs exceeded estimates? Greetings stores
were able to generate a considerable volume of business for Wall Décor. This
helped spread the high e-business operating costs, many of which were fixed,
across many unframed and framed prints. This experience taught top management
that maintaining an e-business structure and making this business model
successful are very expensive and require substantial sales as well as careful
monitoring of costs.
Wall Décor’s success gained widespread industry recognition. The business
press documented Wall Décor’s approach to using information technology to increase
profitability. The company’s CEO, Robert Burns, has become a frequent
business-luncheon speaker on the topic of how to use information technology to
offer a great product mix to the customer and increase shareholder value. From
the outside looking in, all appears to be going very well for Greetings stores and
Wall Décor.
However, the sun is not shining as brightly on the inside at Greetings. The
mall stores that compete with Greetings have begun to offer prints at very competitive
prices. Although Greetings stores enjoyed a selling price advantage for a
few years, the competition eventually responded, and now the pressure on selling
price is as intense as ever. The pressure on the stores is heightened by the fact
that the company’s recent success has led shareholders to expect the stores to
generate an above-average rate of return. Mr. Burns is very concerned about how
the stores and Wall Décor can continue on a path of continued growth.
Fortunately, more than a year ago, Mr. Burns anticipated that competitors
would eventually find a way to match the selling price of prints. As a consequence,
he formed a committee to explore ways to employ technology to further
reduce costs and to increase revenues and profitability. The committee is comprised
of store managers and staff members from the information technology,
case 4
CA-14
Greetings Inc.: Capital Budgeting
Developed by Thomas L. Zeller, Loyola University Chicago, and Paul D. Kimmel,
University of Wisconsin–Milwaukee
cases 1 Cases for Management Decision Making Greet ings CA-15
marketing, finance, and accounting departments. Early in the group’s discussion,
the focus turned to the most expensive component of the existing business
model—the large inventory of prints that Wall Décor has in its centralized warehouse.
In addition, Wall Décor incurs substantial costs for shipping the prints
from the centralized warehouse to customers across the country. Ordering and
maintaining such a large inventory of prints consumes valuable resources.
One of the committee members suggested that the company should pursue a
model that music stores have experimented with, where CDs are burned in the
store from a master copy. This saves the music store the cost of maintaining a
large inventory and increases its ability to expand its music offerings. It virtually
guarantees that the store can always provide the CDs requested by customers.
Applying this idea to prints, the committee decided that each Greetings store
could invest in an expensive color printer connected to its online ordering system.
This printer would generate the new prints. Wall Décor would have to pay a royalty
on a per print basis. However, this approach does offer certain advantages.
First, it would eliminate all ordering and inventory maintenance costs related to
the prints. Second, shrinkage from lost and stolen prints would be reduced.
Finally, by reducing the cost of prints for Wall Décor, the cost of prints to
Greetings stores would decrease, thus allowing the stores to sell prints at a lower
price than competitors. The stores are very interested in this option because it
enables them to maintain their current customers and to sell prints to an even
wider set of customers at a potentially lower cost. A new set of customers means
even greater related sales and profits.
As the accounting/finance expert on the team, you have been asked to perform
a financial analysis of this proposal. The team has collected the information
presented in Illustration CA 4-1.
case 4 Available Data Amount
Cost of equipment (zero residual value) $800,000
Cost of ink and paper supplies (purchase immediately) 100,000
Annual cash flow savings for Wall Décor 175,000
Annual additional store cash flow from increased sales 100,000
Sale of ink and paper supplies at end of 5 years 50,000
Expected life of equipment 5 years
Cost of capital 12%
Illustration CA 4-1
Information about the
proposed capital
investment project
Instructions
Mr. Burns has asked you to do the following as part of your analysis of the capital
investment project.
1. Calculate the net present value using the numbers provided. Assume that annual cash
flows occur at the end of the year.
2. Mr. Burns is concerned that the original estimates may be too optimistic. He has suggested
that you do a sensitivity analysis assuming all costs are 10% higher than expected
and that all inflows are 10% less than expected.
3. Identify possible flaws in the numbers or assumptions used in the analysis, and identify
the risk(s) associated with purchasing the equipment.
4. In a one-page memo, provide a recommendation based on the above analysis.
Include in this memo: (a) a challenge to store and Wall Décor management and
(b) a suggestion on how Greetings stores could use the computer connection for related
sales.
Explanation / Answer
Dear All,
Can anyone provide me the solution for this case? Thanks in advance.
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